What an interesting and humbling year it’s been. After 2017, expectations were ripe for a reset, and that sure has happened. Amazing what paradigm shifts can do.

Many readers are probably suffering from “2019 Forecasts” fatigue, so I will try to keep things brief. As always, disagreements & criticisms are not only appreciated, but requested from readers!

Economics

The slowdown in money growth is being felt globally. Of the big 3, the European and Chinese economies are facing particularly tough conditions because the banking systems are undercapitalized relative to its balance sheets. This means that without central bank liquidity, money supply growth slows dramatically. Until that changes, it will be difficult to bet on a sustained re-acceleration. The US is in a much better spot in that regard, but even there, the impact of higher interest rates is clearly impacting rates sensitive sectors. The consensus view is that we are now late cycle and a recession is likely in 2020. I think this is a too early, unless Fed Funds hit 3% before the end of 2019.

Central Banks & Rates

It’s worth noting that the tightening in financial conditions is the entire point of Fed hikes. Similarly, the market pressure on Italy’s fiscal situation during its negotiations with the EU is part of the ECB’s goal. So neither should be seen as sufficient conditions on their own for the two central banks to reverse course. What has changed in 4Q is that the data has clearly started to turn lower, and the size of the financial tightening implies that the slowdown is likely to extend further.

The European data started slowing first, which suggests the ECB will move earlier than Fed – subject to the Italians & Brits, of course. I think there will be some serious constraints on ECB actually hiking, but the current market pricing is not all that attractive to fade given the headline risks, IMO. Readings for ECB hikes north of 50bps provides good opportunities for mid-curve receiver positions, IMO, where roll down to premium exceeds 3x.

The US data WILL slow further, however, so it’s just a matter of time before the Fed reacts to that. But the market is currently only pricing in 18bps of hikes for all of 2019. With growth still positive and well above zero, that number just seems too low. In fact – using OIS swaps over the next two years, the market is now pricing in more hikes by the ECB (32bps) than the Fed! (23bps) Recall that unemployment is at 8.1% in Europe and 3.7% in the US. From a modal perspective, there is clearly a disconnect. Mathematically minded readers will note that one reason explaining the disconnect is that the ECB is much closer to the zero bound than the Fed. After all, if a recession does hit, the market can price in a lot more cuts for the US than Europe. But if we assume that the Fed cuts to zero in a recession and the ECB keeps the deposit rate unchanged, the implied probability of a recession over the next couple years relative to the SEP baseline is about 1 in 3. There are lots of ways we can further quantify whether that makes sense, but to me, that seems too high. Betting on a more hawkish Fed like a good proposition. The question on timing is, as usual, paramount. Ultimately, the question for rate markets is: at 2.25% Fed Funds, have we reached the terminal level for the cycle? If the answer is yes, then the current market pricing is justified. But I think that is a question that the market won’t be able to answer until growth rates bottom and can re-accelerate. And given that financial markets are driving the deceleration this time, we should probably wait for risk assets to stabilize for a period before entering. A bit obvious, perhaps, but it can be easy to forget obvious things when things are volatile.

Also – for those that missed it, the changes in the Fed’s FRB/US model was very interesting, and should have an impact on your expectations for the Fed’s reaction function. Note that inflation variables in the model now has significantly lower sensitivities to shocks. Per the Fed:

Although the sensitivity of the inflation process has declined in the new model, the smaller short-term responses of the inflation variables reflect not so much the changes to the model as they do the re-estimation of the wage-price block equations over a longer sample period that now extends through 2017… A second noticeable feature of the responses between the models is a faster convergence of the response of many variables back to the original baseline in the long run.

Credit spreads have been affected by a couple of things this quarter: first the downgrade of GE, which was a shock due to the size of its stock of debt, how widely it’s held, and the speed of the downgrade. Secondly, the decline in WTI oil prices below 50 drove renewed concerns around the default risk of energy companies. When combined with the generally poor liquidity of the corporate bond market, slowing profit growth and the record high debt / EBITDA measures, spreads widened dramatically relative to what the economic data alone would suggest. In addition, the year end illiquidity is likely having a supportive effect on where some small credits are marked. Some credit managers have suggested to me that there could be a jolt lower for these prices in the new year as the bonds finally clear. We’ll see.

The Equity Risk Premium is pretty high – cheap by >10% for major equity indices by my calculations, and not seen since Feb and before than Oct 2016. There is a disconnect between equity and credit prices here. Either credit should weaken further or equities should be higher. Will the new year turn things around, as risk takers start with a fresh slate and PnL? I think so, but think this is also the consensus view. So if there ISN’T a rally in January – watch out!!

One factor for the size of the equity sell off is almost certainly because to the reduction in market liquidity. As documented by Goldman (below) and others, single stock and S&P futures liquidity & market depth is at the lowest level in years. This is undoubtedly a result of the move into passive instruments. This instance can certainly be different, but note that historically these periods of illiquidity have all been good buying opportunities for equities.

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I think that the 1987 narrative is may be somewhat illustrative of current conditions. Economic growth was decent in 1986, and looked likely to get stronger in 1987. Unemployment had dropped rapidly and were not far from making 10 year lows. This prompted a hawkish Fed and a jump in yields. (in orange below) The 200bps jump in 10y yields from June to Oct, in conjunction with portfolio insurance programs, drove a 33% peak to trough sell off. While that was a major financial shock, growth remained strong. The Fed cut rates but had fully reversed the cuts 6 months later, and 10y yields were broadly range bound for the next few years. Equities made new highs in mid 1989, about 2 years after the prior peak.

This time around, the Fed is similarly concerned about overheating (financial overheating at least) and were guiding yields higher. The 3.24% print on 10y yields was the highest in 7 years. Furthermore, the combination of low liquidity from algorithmic market making, (see charts above) substantial increase in passive investment vehicles, and the prevalence of volatility driven investment systems provides an accelerant for the risk off move similar to the portfolio insurance programs in 1987.

S&P earnings per share is up +19% YoY. (sorry there was a typo before) S&P Prices are down -9%. That’s a -28% differential. Differentials that big have been pretty infrequent historically – we’ve only seen worse than -25% swings 5 times before over the past 40 years. 1984, 1988, 1994, 2002, 2010. The returns of the next years were: +26%, +27%,+34%,+26%,+0%. The returns in 2011 weren’t so hot because that was during the EU crisis, when people thought the Euro was going to implode.

Note that it is also year 3 of the presidential cycle, which has historically delivered much bigger returns than in the other years. The media reports that Trump views the stock market as an indicator for his presidency, so it shouldn’t be a shock to see some additional fiscal stimulus coming down the pipe. Whether that will be positive over the long run is questionable of course, but is certainly an upside risk in the near term.

FX & Commodities

The dollar has been quite muted over the past couple months. Looking at the charts alone, it would be hard to see that we’ve had the biggest risk off move in a couple years this quarter. From a market tone perspective, I think that means the bias for the dollar is lower. Weak EU growth and an reticent ECB is already in the price here. A stabilization of global growth, even at low levels, has a good chance of propelling the dollar weaker. The possibility of further US fiscal stimulus is another dollar bearish risk. Finally, BAML’s fund manager survey has long dollars as a crowded/most-loved trade. (see chart) As noted elsewhere, the EU (mainly Germany) current acct balance is now very high, and that is changing the sensitivity of the EUR/USD cross to risk conditions. This is something that will be important to monitor, I think.

The 1y1y WTI strip is now around $50 which is reportedly below the cost of production for a lot of shale sources. In theory, that will cause a lot of supply to close up and bring the oil market back into balance. Certainly, that was the case in 2015 and 2016. However, it’s important not to forget that the shale producers wound up figuring out lots of ways to increase efficiency then, meaning that the true level for “break-even” in mid 2016 wound up being notably lower than the assumptions made in 2015. Ultimately, the oil market will probably need to see some stabilization in the inventory builds before there can be confidence that the supply is really adjusting sufficiently. That may be starting to play out, but it’s still early days.

EM

Chinese growth is weak – no news there. What’s different is that there just hasn’t been a sizable monetary response like we saw in previous cycles. One of our Chinese academic contacts has noted that unemployment and economic distress is actually quite widespread, and in no way reflected in the reported data. Again, not shocking, but given the context of the slowdown and the trade war, there are a number of legitimate questions about what the economic plan really is. With Xi’s power unquestioned, the trade war in full swing, and the prevalence of large amounts of non-economical debt broadly recognized, it’s quite possible that China is finally attempting to do necessary to rebalance its economy. The need to reduce debt while at the same time limiting reliance on net exports and reorient GDP towards consumption, all with a declining labor force is an extremely difficult task. In this context, Chinese government bond yields look too high.

Also worth noting is that the outlook on EM stocks is now the most bullish in 10 years, according to BAML. Valuation measures like CAPE are certainly supportive, but the secular changes that have taken place, along with the institutional challenges, remain quite worrying.

Announcement

After a number of years in my current seat, I am now actively hunting for a new role. If any readers know of a position that could use a global macro and/or asset allocation mind set, in either an advisory or portfolio management role, I would sincerely appreciate the opportunity to discuss it. Thanks for reading and Happy Holidays!

+1.5% on the notional of an Ultra contract a year ago. I assumed shorting new quarterly puts at the close on the day the older puts expired. A year ago the consensus was fairly heavily tilted toward higher rates, so this one worked fairly well in early in the year.

Long US Leveraged Loans outright or HY on duration hedged basis

The S&P Leveraged Loan 100 index returned +3.3%. Default rates were low and the Fed hiked.

Long USDCAD

-3.0%. This one was looking pretty decent in early May, but turned around rapidly after that as the BoC turned sharply hawkish in mid June, as the unemployment rate began falling sharply. They’ve backed off a bit since, as inflation has remained benign. In retrospect, I didn’t pay enough attention to the surge in employment in 4Q of last year.

Long S&P vs Russell

+7.2%. Probably a surprise to some folks given how well the economy has done as well as the tax bill headlines. IMO, much of that was already in the price a year ago, and the tech sector helped a lot also.

Hit rate: 3 for 4. The results certainly weren’t exciting, but they worked, and delivered on low volatility and low correlation to major asset classes. For a macro mandate, it wasn’t terrible, especially since the industry results were pretty paltry in general. The general backdrop for 2017 was one of low macroeconomic and asset class volatility, which meant very few opportunities in macro space. IMO, the best macro opportunity of the year was in Sept, when the market pricing for the Fed got crazy dovish on the back of the low inflation prints. I discussed this a bit in my last note back in Sept.

2018 Macro Thoughts:

The consensus is for another decent year economically speaking, and it’s hard to find data that suggests otherwise. I’m sure readers have already read many versions of “2018 Outlooks” already, so I’ll try to avoid repeating the more consensus views. The unfortunate byproduct of that kind of forecast is that mispricings will continue to remain scarce, and the long carry / long risk trades will remain in vogue. I don’t see anything that suggests 2018 will be a great year for macro strategies, though in that I hope I’m wrong.

I think the Fed will hike more than is priced in, but the market will only adjust gradually. I don’t think yields will be a problem until we get at least above 2.25%, which means it’s probably a 2019 problem. Given the current trends in train, we may see a bit of volatility in the spring. Core PCE seems likely to pick up at the end of 1Q on a YoY basis. Given consensus expectations though, the risks seem skewed toward them staying pat in March and only hiking after realized inflation picks up, though another noticeable drop in the unemployment rate would likely trigger sequential quarterly hikes. The FOMC voters next year are noticeably more hawkish than the ones this year, though it’s unlikely they’ll rebel against Powell given that it’ll be his first year. There seems to be some sympathy for price level targeting at the Fed currently, which if adopted would give the Fed leeway to keep policy easier. (It’s also possible the Fed rolls it out in lieu of forward guidance in the next recession) If so, we could see a replay of the late 90’s, whereby a lack of financial condition tightening, along with regulatory easing results in a renewed series of financial bubbles. Regardless of what happens, the Fed’s actions in 2019 will lay the groundwork for whether there is a recession early in the next decade.

I’ve been saying for a few years now that for 30y treasuries, 2.75-3% is fair, and the Fed dots seem to agree. Part of the rationale is the decline in inflation uncertainty, which GS has noted, though the decline in policy uncertainty has helped as well. That’s one reason I think US equities are valued fairly here, and if anything a bit on the cheap side. And that’s before taking into account the balance of risks for next year.

European growth is likely to remain robust, but has not translated into good earnings growth. EU core inflation is likely to pick up by more than is expected, but my guess is that the ECB will try to continue to buy more time for the Italians to get their debt situation under control. Fortunately, at current yields and nominal growth rates, Italy is in the clear. The weak earnings growth, however, significantly weakens the value proposition for EU Equities. In general, I see valuations there as fair to rich, despite the sharp underperformance in local currency terms this year.

Unlike the US and Europe, the Chinese economy is likely already slowing. Knock on effects look likely in 1Q, and possibly concentrated in the metals complex. The consensus is that Chinese policy makers have learned from the 2015 growth scare are will be much more careful this time around, which means the slowdown will be mild. That’s certainly pretty reasonable, but the risks are clearly skewed toward a worse outcome, especially given the size, complexity, and leverage levels.

In general, the consensus seems to be pretty bullish EM assets, and from a valuation perspective, it’s hard to disagree. However, it’s worth noting that historically, EM equity outperformance has been driven by a weakening dollar. The BIS, among others, have noted the procyclical effects of stronger EM currencies easing EM financial conditions. So to me, the EM equities bet is strongly related to a bet on a weaker USD. The problem is that I am not convinced that we’re about to embark on a sustained bear market for the USD yet – it doesn’t seem all the pieces are yet in place. On the other hand, EM sovereign debt looks fairly attractive vs DM High yield. EM economic conditions look fairly benign, while delivered DM High Yield defaults are at unsustainably low levels.

2018 Ideas:

Go long a 50/50 basket of S&P 500 and 30yr US Treasuries.
I’ve been writing about the insurance aspects of risk free assets within a portfolio. It’s worth noting that with Bunds, Gilts and especially JGB yields where they are, the amount of insurance they provide in a global risk off is significantly lower relative to previous cycles. (i.e. how much are JGB’s going to go up / pay out in a recession from these levels?) In conjunction with the higher debt loads everywhere, there is a real cap on how high yields can go. Furthermore, GS has noted that the decline in delivered inflation volatility had a major impact on implied volatility on the long end, with likely knock on effects on the term premium as well. 30y yields at 2.90% or so is in my fair value estimate, and as a result provides some portfolio insurance at a reasonable cost.

Short AUD vs USD.

A play on the Chinese slowdown that is in train. Inflation in Australia, like in other DM countries, has remained low, and the RBA is reluctant to hike, especially given the high debt load and the level of the currency. Currently the negative carry is deminimis and looks likely to turn positive later this year (!) given market pricing and consensus forecasts.

Long MIB vs SX5E.

Italian companies seem to have shaken off many of its legacy problems and its relative growth profile has picked up. Looks like the market isn’t buying it just yet, so this looks like a decent entry point.

Long Bitcoin.

Because it’s going to change the world, something something. Because you can’t trust governments. Also supply is limited. And it’s totally worth it to pay $25 in fees and wait 15 minutes per transaction for an asset with an annualized volatility of 100%. Finally, and most importantly, because the price is going up. Like a lot!! What are you going to do, not buy it?!? FOMO dude!! This guy gets it: “valuation is immaterial.”

In case it’s not obvious, the last one’s a joke. Some of the stuff is just so out there you have to laugh a bit. I wish there were more substantive ideas, but between the market landscape and other responsibilities taking up my time, I couldn’t find more ideas compelling enough to hold for multiple quarters. As always, constructive criticism is welcomed!

The market is currently pricing just ~0.35% of hikes over the next TWO years. The infamous Fed dots imply ~1.75% of hikes. Even with the knowledge that the Fed dots have been way too high the past several years, that gap is very, very large. The consensus view seems to be that the market has lost faith that inflation will return to anywhere close to 2%.

But that doesn’t really seem to be the case. According to Bloomberg, the median private sector economist projection for core PCE at the end of 2018 is 1.8% vs the Fed at 2.0%. 1y1y inflation forwards are pricing in a headline CPI of roughly 2.0%. So I have a very hard time believing that the consensus actually think a lack of inflation likely.

In fact, betting on more hikes appears to be a popular or even crowded trade now, with Bloomberg actually running an article this morning entitled: “Bond Market’s Hot Trade is Betting a 2017 Fed Hike Still in Play.”

So if the market doesn’t believe that the Fed will stop hiking, and may in fact be betting for more hikes, the big question is: why is bond market pricing so different?

There isn’t a smoking gun type answer to this one, and probably never will be. But my hypothesis is that there are two primary factors: the shortage of risk-free bonds, and their insurance properties. Neither hypothesis are all that novel, but perhaps some of the conclusions will be of interest.

The bond shortage argument has been around for a long time. Many banks have tables showing annual net issuance of risk-free bonds, after accounting for QE programs, relative to demand from private sector investors like pension plans and the like. That gap has been very wide, and in addition has recently exacerbated by the increase in USD FX reserves. (Foreign central banks tend to park their USD reserves in US treasuries, mainly at the front end of the curve. The recent rally in EMFX has allowed many of them to replenish their reserves, which are now back to mid 2016 levels)

In addition, since the 1990’s, risk free bonds are essentially the only asset class that is negatively correlated to risky assets. In other words, they provide insurance for the rest of a portfolio. An in a world where asset prices are universally deemed expensive, the price of insurance should naturally rise.

In fact, insurance, as we all know, typically costs money. So if owning treasuries are akin to owning insurance, should we be shocked that owning treasuries… ultimately costs money, relative to cash?

To some extent, the various term premium models out there showing negative readings across the curve already says that. Consensus views seem to remain that term premiums will revert to above zero over the long run, after QE programs are unwound, etc. But if QE becomes a recurring part of the central bank tool kit, as most central bankers assume, it may well be that negative term premiums are here to stay.

To take the insurance analogy a bit further – historically insurance pricing fluctuates such that during quiet periods, insurance companies compete to drive down the price of insurance to uneconomical levels, until a natural disaster or other shock causes the insurance market to reprice as the weaker players are forced to step away from the market. Perhaps we could see a similar dynamic in the treasury market – long periods of notably negative term premiums, until a shock (like an a Fed hike) causes a temporary repricing to more justifiable levels.

For the record, I think the consensus view on inflation is right. My own inflation model, which only puts a minimal weight on the slope of the Philips curve and has done a decent job of forecasting inflation out of sample, suggests Fed and consensus forecasts over the next several quarters look pretty reasonable, and if anything could be on the low side.

In my last note in mid June, I noted that rates looked rich but it wasn’t time to fade it yet, which turned out OK over the longer run. Unfortunately that was immediately before the Sinatra conference, which caused a temporary spike in yields, which has since been more than unwound. At this juncture, I think there is enough uncertainty at the Fed about inflation that they will want to see more than one strong inflation print to hike in Dec. There are only 3 more core PCE prints to be released between now and the Dec FOMC, and 4 CPI prints. So my guess is that the inflation data will need to start strengthening very soon for a Dec hike to be realistic. In addition, since the recession there’s been a seasonally bearish bias to the MoM core PCE prints in the last few months of the year. So my personal take is that current market pricing for Dec isn’t all that crazy.

· Credit spreads look a bit tight, but there’s nothing that suggests a reversal is likely. I’ve been hearing that underwriting for leveraged loans have been weak given strong demand, but that could persist for some time.

· Spec positioning on the dollar is starting to get stretched, but I don’t think it’s a binding factor – yet. I don’t think the USD is terribly mispriced – fundamentally, the trend turned in 2014, IMO.

· Equity prices still look pretty reasonable here. I don’t think a Fed hike or QE unwind will cause a major correction. A major reason is that the long end of the curve doesn’t look too out of whack.

First, a quick note. I haven’t posted many updates this year because frankly, I haven’t seen a whole lot of mispricings. My last post on in late Feb suggested getting long duration, which has worked out OK. I think rates are a bit rich currently, but the backdrop suggests more downside is likely over the rest of the summer. I actually think equities are pretty fairly priced here. Prices had ramped up ahead of fundamentals earlier this year, but it seems like the fundamentals have now caught up.

I’ve been thinking a bit about how this business cycle could play out. Historically, falling unemployment has generated rising inflationary pressures, which causes the Fed to hike enough to trigger a recession. What’s different this time is that falling unemployment has not been generating much inflation at all. The scenario being priced in by fixed income markets is that this will cause to Fed to slow or significantly shorten its hiking cycle. That’s certainly plausible to me. I don’t think anyone can rule out a scenario whereby very low unemployment rates coincide with low inflation. After all, we are already seeing it in many countries across the globe like Japan and Germany. And then there’s the chart from Haldane at the BoE that purports to go back to the 1500’s: that suggests no relationship before the industrial revolution:

But there’s another possibility, which is that unemployment will cause inflationary pressures only when unemployment is low, but then the inflation will accelerate. i.e. the slope of the Phillips curve is non-linear. Goldman recently published a study of the relationship between inflation and unemployment by metropolitan areas, which provides some support for this hypothesis.

In addition to that, there is data in US history that support this. The time periods in the early 50’s and the early 60’s exhibited both low unemployment (in blue and inverted below) and low inflation. (cpi in red) That period ultimately led to the inflationary spiral that dominated monetary developments for the subsequent decade.

Now, obviously this is not the 1960’s. We don’t have the baby boom wave coming, and rather than an inflationary oil shock, we are getting a deflationary oil shock. But the data as well as the rhetoric from the current Fed suggests that – as long as unemployment continues to fall, hikes are likely to be forth coming. In fact, that is exactly what the Fed did in the late 90’s, despite inflation that is only a bit higher than current levels. After all, the Fed doesn’t know how things will play out – whether unemployment and inflation will completely decouple, or whether some relationship still exists. So it will most like try to tread a path in the middle, that will allow it to accelerate or decelerate tightening as evidence for either case unfolds. Put differently, if unemployment is at 3.5% in a year’s time, the Fed is likely to be hiking still, even if inflation is unchanged.

The lowest unemployment reading in US history is 2.5%. If we extrapolate the trend decline in unemployment since it peaked, we could be there in 2019 – just 2 years away.

The Fed will want Fed Funds to be at least positive then on a real basis, which means 2.25% nominal. That’s another 4 hikes, or roughly 2 per year. But the risk is clearly tilted toward more hikes. The SEP median dot is near 3% for the end of 2019, with the unemployment dot basically unchanged from the last reading and core inflation at 2%. That’s pretty undemanding. And I think that because of the analysis above, the dots are sticky. Well, at least stickier than dots were in the past – simply because of the possibility of accelerating inflation.

In addition, my estimate is that 3.5% Fed Funds is highly likely to tip the economy into a recession. (a very very big) If things play out as listed here, that suggests 2020 as the potential start of the next recession.

Now – how is this useful, even if this scenario somehow plays out? Put differently, how could assets perform if this expansion extends another three years? There aren’t a lot of precedents, but here are a few thoughts:

· China’s forced rebalancing away from credit growth could be delayed until then. But the impact of a US recession on China could be yuuuuge….

· Corporate leverage ratios could make all time highs. Stock buybacks could increase until then

· I don’t think a huge equity bubble is particularly likely. The psychological pain from the past two recessions are probably going to stick around for a generation – I think if another equity bubble will happen this time, we would’ve begun the see signs already. Certainly we didn’t get an equity bubble in the 1950’s. A corporate credit bubble seems more likely to me given the massive demand for debt, the easing of covenants, and the fact that most corporate credit ex-financials did OK the last time around

· But by bubble, I mean equities may not get to levels that result in a crash. But they certainly could get to a very high plateau and stay there. A model that extrapolates 10y nominal price returns suggest that current prices embed a 2% return annually. There’s a pretty good chance that if the cycle goes to 2020, that figure goes down to zero. But that could be ~30% higher from here in price terms.

It’s been 3 months since global yields gapped higher, and the consensus view remains quite bearish. Expectations for Fed hikes this year haven’t changed that much from the 2-3 hike range, which means the consensus seems heavily skewed toward steepeners.

I’d like to use this note to elaborate a bit about why those views may be wrong, and then go over some developed country bond markets individually. My guess is that some readers will be familiar with various components of the arguments set out below, but hopefully everyone will find an interesting piece of food for thought by the conclusion. As always, discussions and disagreements are welcome.

Preamble

I think one of the major things folks miss when they project rates going back to some historical average is that they do not take into account the fact that past economic outcomes were burnished as a result of falling rates. Sounds trivial, but it doesn’t seem to be broadly incorporated into expectations of asset returns. To be more concrete: US growth is currently what it is because of the continuous decline in US yields since the end of 2013. For growth to persist at current levels AND yields to move significantly higher would require a huge source of growth from some other sector of the economy. That would be bigly!

The Philadelphia Fed has a quarterly survey asking economists their expectations. One of them is their expectations for the nominal return on 10yr treasury bonds. Now, perhaps it’s not a surprise that actual 10yr Treasury yields have been lower than the average survey response. But it is worth noting that since 2000, the difference between the market rate and expectations averaged 130bps. Talk about bias!

To be fair, many of the models that economists use (especially at central banks) have embedded features that allows for past interest rates to affect equilibrium estimates. That is one reason why the FOMC’s estimate of long run Fed Funds rate has been consistently falling for the past several years. But unfortunately, it seems not many folks fully adjust their views to real world outcomes!

Japan

This is probably the easiest one. Consensus forecasts for 10y JGB yields in a year’s time is just 11 bps, basically unchanged from current levels. And the reasoning the pretty clear. Japanese inflation has hovered around zero for the past two decades despite multiple efforts by the BoJ to raise it. The vast majority of the variation in core CPI inflation after adjusting for taxes has simply been a function of the Yen:

This is already reasonably well accepted by market participants, which is why the various discussions around the BoJ potentially raising the 10bp cap on JGB yields isn’t all that credible. Even the most hawkish member of the BoJ has warned against it. So barring either a break in the two decade long relationship above, or a change in the BoJ mandate away from positive inflation targeting, JGB yields look likely to continue trading in this range for the foreseeable future.

Europe

…is a mess. Nothing new there. Most of the noise around Europe seems to be on French politics right now, but I think it’s just a distraction from the bigger problem. Which is that the Italian sovereign bond yields are unsustainable without purchases by the ECB.

Italian government interest payments alone have been stable at around 4%-5% of GDP over the past decade despite both the 30% jump in debt/GDP and the slowdown in nominal GDP growth. That’s been the case only because of ECB purchases, which has pushed 7y BTP yields from ~4.5% a decade ago to just ~1.6% now. Even with that however, interest payments at 4% of GDP are unsustainable with nominal GDP at less than 2%:

The current debt distribution according to Bloomberg is front loaded, with an average maturity of 6.7 years and a weighted average coupon of 3.36%.

With current BTP yields well below the average weighted coupon, and given that we know the debt maturity profile, we can make an estimate of how long it will take for interest payments to fall to sustainable levels. I’m going to define sustainable at 3% of GDP, which is giving Italy the benefit of the doubt given that nominal Italian GDP growth has printed above 2% YoY just once in the past 5 years. We’ll also assume that the primary deficit balances the interest payments such that the debt to GDP ratio stays stable at 135%. If we assume that the BTP curve holds constant, and the maturity profile is held constant, and nominal GDP is stable at 2%, interest payments as a percent of nominal GDP will evolve as follows:

Now: 3.36% avg coupon * 1.35 debt/GDP = 4.5%

2018: 2.97 * 1.35 = 4.0%

2019: 2.73 * 1.35 = 3.7%

2020: 2.51 * 1.35 = 3.4%

2021: 2.37 * 1.35 = 3.2%

2022: 2.23 * 1.35 = 3.0%

Put differently, if we optimistically assume BTP yields do not rise much more from here, growth and inflation remains at current levels (i.e. no more growth shocks), and debt/GDP remains stable, it will take another 5 years before interest payments fall to a plausibly sustainable level. It seems quite unlikely that the ECB will be able to step away from buying BTPs until we are close to that level.

In addition, consider the fact that the “mark to market” level for interest payments as a percent of GDP, which I define as Debt/GDP * 7y yields, cannot stay more than 1% above nominal GDP growth for very long without yields jumping higher. That’s because such a move would result in a self-reinforcing spiral akin to what we saw during the EU crisis. Higher yields => worsening fiscal picture => higher yields. With sustainable nominal GDP likely not much higher than 2%, this probably means around 3% or so, which on 135% debt/GDP implies a ceiling of ~2.25% on 7y BTPs.

To me, this means that the ECB will have to keep 7y BTPs yields not much above 2.0% until at least 2021. It’s very hard to see that happening without some sort of QE program.

Of course, the ECB is not allowed to buy only BTPs. It will have to buy bunds as well, which is already a problem due to scarcity. I think the market has been sniffing this story out the past couple months, and one reason why 2y German yields have dropped to new lows even as 2y yields elsewhere have been stable. Here is a chart of the spread between an average of French, Spanish, and Italian 2y yields vs German 2y yields:

After converging to a range around 35bps or so, spreads have moved back to ~70bps, a level not seen since the end of 2013. In fact, 70bps was a key resistance level that marked the beginning of the EU crisis back in 2010. This 70bps level is a line in the sand, in my opinion. If spreads break above it, we will see periphery spreads widen out until the QE tapering is reversed.

United States

The impact of the items I listed earlier is likely impacting the US market the most via the term premium. The term premium is defined as the compensation that investors require for bearing the risk that short term Treasury yields do not evolve as they expected. The most well known measure is the ACM estimate, which the NY Fed has discussed. Currently, the ACM 10y term premium estimate is around zero, which is quite low relative to history. A common theme that many bond bearish articles have discussed is that the term premium could revert back to longer term averages, which is in the neighborhood of 1.5%.

However, a closer look at the term premium shows that it’s actually highly correlated to the spread premium of US treasuries relative to the rest of the world. The chart below plots the 10y ACM term premium in white, and the yield difference between 10y treasuries and a basket of 10y bunds, gilts and JGBs in orange and inverted. As the chart shows, the higher the yield advantage treasuries offer relative to the rest of the world, the lower the term premium. Which makes sense!

The implication then, is that if both the BoJ and the ECB are not able to allow yields in their countries to move much higher, the spread between treasury yields and the rest of the world is not likely to tighten. Which suggests that the risk is not that the US term premium could rise, but that they could fall further!

There are many other factors that affect yields that I haven’t discussed here, but I think it the analysis above presents a compelling argument that the top for US yields is likely to be quite a bit lower than consensus expectations.

Implications

Market tone in Fixed Income is very bullish currently. In the past few weeks, we’ve had:

4. strong data globally, with the Citi G10 economic surprise index at levels not seen since 2010(!)

5. strong performance in risk assets

And yet long term yields have not moved higher! Literally, we’ve had almost everything a bond bear could ask for, and yet US yield are lower YTD and looks ready to break below support that has held since Dec:

If yields can’t go higher on good news… what will? In my last note in early Dec, I suggested getting some exposure to duration via selling out of the money puts on 30y treasuries. I think it’s time to upgrade that view to building duration outright.

Before we get to the ideas, a quick note on my predictions and ideas from the past year. Overall, it’s been a decent year for my calls. Part of that is due to the major swings in asset prices over the course of the year. Here were my key calls and subsequent market price action: (I used SPX as the proxy for risk assets and 5y Treasury yields as a proxy for risk free rates)

On 10/22/2015, I wrote ‘It’s time to be Neutral or Short Risk.’ (assets) That proceeded a 13% drop over the subsequent 3.5 months:

On 1/21/2016, I wrote ‘It’s time to start building exposure to risk assets.’ That was a bit before the ultimate low (which I acknowledged was likely at the time), but was subsequently followed by a double digit gain over the subsequent 3 months:

On 6/23/2016 I wrote ‘Here comes the Squeeze,’ where I noted that equities were likely to rally regardless of the Brexit referendum outcome.

On 8/22/2016, I wrote ‘It’s time to short the front end,’ where I argued that it was time to bet on higher rates:

To sum up, most of the intra-year calls have worked out, though it seems I was a bit early on all of them.

My 2016 ideas all showed nice profits at mid year, but have retraced much of their gains over the past month.

· Short CHF vs JPY worked pretty well. Regular readers will recall that I proposed taking profits when the cross was at 106 mid-year.

1. 12/11/15 level for 12m fwd: 123.84

2. Current Spot: 112.22

3. PL = +8.4%

· Short AUD vs USD. This trade hit a 5% profit within a month of initiation, but gave it all back. The PBoC easing starting in late 2015 was the main factor that knock the trade into a loss.

1. 12/11/15 level for 12m fwd: 0.7073

2. Current Spot: 0.7460

3. PL = -3%

· US 5s30s Flattener. This trade was up +35bps by the end of Aug, when I’d suggested potentially booking profits. Since I proposed going short duration, the trade has gone back to flat.

1. 12/11/15 level for 1yfwd 5s30s in swaps: 0.742

2. Current Spot: 0.726

3. PL = +1.5 bps.

Thoughts about the Current Macro Environment: (This will provide some context for the 2017 trade ideas)

The global economic & inflation rebound has some more room to go. The current economic momentum and some leading indicators suggests another quarter or two. The deflation / recession mindset that was in place for much of last year is now a good base against which the economic cycle can extend. EM balance sheets are now fairly healthy, (though potentially at risk if the USD strengthens a lot more) and FX levels undemanding.

Global cyclical indicators are now close to the peak levels seen from late 2013 – late 2014. (below chart is from GS)

With G8 unemployment now near multi-decade lows, it is questionable how much the acceleration can continue.

The biggest long term risk remains rapidly tightening monetary policy. By my estimates, US policy rates above 3% would be enough to trigger a recession. We’re obviously still a ways from that, but by the end of 2017, we could be almost halfway there. In contrast with the low odds of recession near term, I think the odds of a US recession during 2019-2021 period is quite high. How quickly policy actually tightens, however, will be dependent on the evolution of fiscal policy and inflation. That’s one reason I’m hesitant about making any longer term bets on the belly of the curve.

I don’t think there’s that much upside left for equities, at least on a risk adjusted basis. On my models, they are already trading rich, but that may well be justified due to the corporate tax cuts that Trump has talked about. GS noted that a reduction in effective corporate taxes by ~10% could increase EPS by ~15% or so. That certainly justifies some sort of premium, but further gains on that front will require some legislative details. DM yields and equity valuations are roughly in balance here, so a further rise in yields will be a significant headwind for equities, though rising earnings will provide some offset.

Nevertheless, it is key to recognize that thereis more uncertainty now about the appropriate risk free discount rate than at any time since the end of 2013. This key input that goes into essentially every asset valuation model presents a key source of uncertainty that lowers the conviction on any calls one can make. Note that this uncertainty is also being reflected in vol space, as rates and FX vol are both quite high compared to the past 5 years.

There is a limited amount of upside for 30y yields from here. The global savings glut and wealth inequality is not going away. No president is going to move us out of the new normal. As global momentum slows at some point next year, those views will be talked about again. In addition, implied vol for US rates is on the high side. Currently, 3m puts are ~1’20 bid, or ~88bps of notional. On an annualized basis, that is roughly 3.5%. I think you are supposed to get long 30y treasuries at that yield, if not sooner, and get longer if the opportunity arises. As I mentioned, I am strongly convinced that policy rates in excess of 3% is likely to trigger a recession, so 3.5% is a good level to lean against.

In addition, per JPM, various positioning metrics suggests that Treasury shorts are now fairly crowded.

On the other hand, it seems unlikely that we will see the highs for yields until at least the end of the year or even inauguration. There is simply too much uncertainty and current yields are not quite high enough to justify the risks. In addition, with economic and inflation momentum on the rise, risks are still biased to the upside. As a result, selling puts provides a reasonable alternative, IMO.

Long US Leveraged Loans outright or HY on duration hedged basis

Though clearing levels for risk free rates are in question, credit spread levels are easier to call. Credit spreads are ~3.6% for loans, and ~3.7% for HY CDX. Given that near term economic risks are low, neither are unreasonably tight given expected defaults and is likely to provide a decent source of vol-adjusted carry. The higher total yield is not a problem – interest coverage ratios remains healthy. (per GS – see chart)

This is a fairly consensus call. Having said that, it is important to be mindful of where we are in the business cycle, and that credit spreads are only somewhat attractive. In other words, it’s not the time to load up on illiquid bonds!

Long USDCAD

After the 1998-2007 oil boom, Canada is suffering from a mild form of dutch disease, IMO. Despite the 25% depreciation in the real effective exchange rate since 2007, the current account deficit remains quite poor at -3.5% of GDP. Over the past 40 years, the only other two periods of such sustained current account deficits saw large depreciations that continued until the deficit was corrected. I think that’s a pretty good template this time around also.

In addition, the trade has the added bonus of being positive carry, and negatively correlated to risk assets.

The biggest pushback on this is that oil is likely to rally, which has historically meant CAD strength. In this respect, it is important to recall that the US is now a major oil exporter – in fact, the net US petroleum trade balance is almost flat, levels not seen since 2002.

Long S&P vs Russell

Higher real rates are negative for small caps relative to large caps. The current levels are already extrapolating a jump in growth:

There’s certainly a bit more room for small caps to outperform, but they seem more likely to mean revert – either due to growth mean reverting or a tightening Fed.

On a final note of clarification, these are not necessarily trades that anyone should hold blindly for the year. But I do think that they provide some interesting risk/reward tradeoffs over a longer time frame that at least will provide some food for thought for readers. As always, thoughts and disagreements are welcome. Good luck and best wishes for a profitable and educational 2017!

Human psychology is fascinating, isn’t it? How quickly has the consensus changed from Trump being a buffoon to Trump could solve secular stagnation? I mean, people should change their views if the facts dictate that they should. But the conviction that some folks maintain, despite doing a literal 180 in a week’s time, is laughable. Strategists have to pretend that they know exactly what’s going on I guess, even if they have no clue. Maybe the pretending gets into their heads. Anyway, last week is a delicious reminder that price action drives the narrative, not the other way around. Here’s a short list of things I think is true about the US political situation, regardless of the price action or the opinion flow:

· Trump is out of his depth. The executive branch is huge, and requires many hardworking, competent public servants. But he will not be able to attract very many qualified political appointees into his administration. His public persona and management style (never accepting blame or backing down) is anathema to many reasonable people who may otherwise jump at the chance for public service.

· But his party has control of Congress

· So the range of possible outcomes is wider

· But given the complexity of the world today, and the low nominal growth rates, mistakes are more expensive.

· Higher vol + negatively skewed outcome distributions is not a good combination

As a result, my assessment of the economic fundamentals has turned more bearish over the long run.

On a separate note, the BAML Fund Manager survey was interesting, even though some responses may have been returned prior to the election. Also note that the sample size has depreciated quite a bit from prior months. Here are a few charts of note:

Inflation Expectations are about the highest they’ve ever been in the 20+ years of the survey:

Historically, that has usually meant a continuation of the steepening already in train.

Unsurprisingly, survey participants also had unusually high expectations for higher 10y yields.

Historical readings at these levels have coincided with or preceded local highs in yields: (late 2003, early 2008, late 2010, mid 2013)

This confirms my view that we are probably closer to the beginning of the end of the rise in yields rather than the end of the beginning.

For equities, the high cash balance which has provided a backstop has fallen somewhat. It’s probably unlikely that cash balances go all the way back down to the low levels last seen in 2011, but on an absolute basis they remain high and will continue to limit the depth of any downside shocks, IMO.

Also supporting this view is the very low levels of allocation to equities:

For the USD, investors are broadly neutral on valuation, but the readings are elevated relative to the past decade. IMO, that supports my view that the USD may not appreciate a great deal more from here – certainly not as much as the 2014-2015 move.

· whereas in 1938 about 19 percent of all federal civil cases went to trial, by 1962 that rate had declined to 11.5 percent and by 2015 it had declined to an abysmal 1.1 percent.

· over 97 percent of those charged in federal criminal cases negotiate plea bargains with the prosecution, and in the states collectively the figure is only slightly less, about 95 percent.2 In most cases, as a practical matter (and sometimes as a legally binding matter as well), the terms of the plea bargain also determine the sentence to be imposed, so there is nothing left for either a judge or a jury to decide. While the immediate result is the so-called mass incarceration in the United States that has rightly become a source of shame for our country, the effect can also be seen as just one more example of the denial of meaningful access to the courts even in the dire circumstances of a criminal case.